Investment Banking
at a Crossroads
Prof Ian Giddy
New York University
Europe’s Future Banking
Banks vs. Markets
 Relationships vs. Transactions
 On Balance Sheet vs. Off
 Domestic vs. Regional vs. Global
 Debt vs. Equity
 Bricks vs. Bytes

Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 2
Banks vs. Markets
Where are investors going?
 What do today’s shareholders expect?
 Where are corporate clients going?
 Where is your bank going?


Common theme: “The end of
entitlement” (which implies the end of
special responsibilities)
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 3
Relationships vs. Transactions





Lower barriers to entry – more price
competition
Frequent re-calculation of benefits: “What will
you do for me next?”
Shareholder pressure weakens traditional
relationships, obligations
In business, the effect is toward alliances,
contract manufacturing, out-sourcing
Stability requires “new communities,” the
more broadly-based the better
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 4
Financial Innovation
and the Shorter Product Life Cycle
More financial innovation
 But most innovations fail
 Fewer geographic barriers to entry
 Fewer information barriers to entry

Excess
returns
Time
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 5
Innovation as Value Creation
Innovations are costly to develop and
produce, and easily copied, so
 For an innovation to succeed, it must
create differentiated value for issuer,
investor, or risk manager, by:

Unbundling:
create simple, more primitive
instruments to isolate risks, or
Bundling: create tailor-made instruments
to reduce costs, minimize taxes, or
circumvent restrictions or imperfections.
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 6
On Balance Sheet vs. Off
“All my assets are for sale, all the time”
 Maximize ROE by increasing capital
turnover – become originators instead
of lenders
Market value of transactions in Europe

(1990-present) Euro bn
70,0
61,7
60,0
Asset-Backed
Securities
50,0
40,0
33,1
35,4
38,8
30,0
20,0
10,0
5,4
9,1
5,7
5,3
6,9
1,6
0,0
1990
Copyright ©2000 Ian H. Giddy
1991
1992
1993
www.giddy.org
1994
1995
1996
1997
1998
1999
(YTD)
European Banking 7
Domestic, Regional or Global?

Which are more mobile?
Goods
markets
Labor
Services
Financial

services
Even domestic institutions must be able
to compete in the world arena
Copyright ©2000 Ian H. Giddy
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European Banking 8
Debt vs. Equity
Index ($)
A $1
10000
Investment
in Different 1000
Types of
Portfolios: 100
1926-1996
10
Small Company
Stocks
$4,495.99
$1,370.95
Long-Term
Government
Bonds
Large
Company
Stocks
$33.73
$13.54
$8.85
1
Treasury Bills
Inflation
0.1
1925 1935 1945 1955 1965 1975 1985 1995
Copyright ©2000 Ian H. Giddy
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Year-End
European Banking 9
Passive vs. Active Investors
It’s an internet information age
 Domestic shareholders want global
returns – asset managers must beat
benchmarks
 Corporations or financial institutions
which cling to underperforming assets
will have lower ROE and share prices
 Which makes them vulnerable to
restructuring or takeover – Europe’s
new market for corporate control

Copyright ©2000 Ian H. Giddy
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European Banking 10
Passive vs. Active Investors
Investors
expect results or sell their
shares; “friendly holdings” become too
costly, opportunity costs become explicit
Venture capital, private equity funds attract
investors by offering higher returns
Market-based returns now expected by
investors and lenders, and required of
managers; local differences persist, but
diminishing
Copyright ©2000 Ian H. Giddy
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European Banking 11
Bricks vs. Bytes
It’s a Nasdaq world, and it’s moving at
“internet time”
 The old economy needs the new
economy to meet shareholder
Check your own
expectations
bank’s online
and mobile
“To B2B, or not to be?”
financial services
 E-business or m-business?
 Equity, not debt, is financing the new
economy

Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 12
Whither European Financial Services?
The Anglo-Saxon model of transparent
financial markets is coming, at internet
speed
 All assets must meet the test of the
market – global shareholder return
standards
 Otherwise…

Copyright ©2000 Ian H. Giddy
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European Banking 13
Example: Deutsche-Dresdner
What is Deutsche’s strategy?
 Does the Dresdner acquisition advance
that strategy?
 What does it take to succeed in
investment banking?

Deutsche-Dresdner case study
Copyright ©2000 Ian H. Giddy
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European Banking 14
The Commercial Banking Model
Assets
Loans

Net interest
revenues
Liabilities
Deposits
 Net interest
costs
Goal: Add assets with positive net interest margin
Copyright ©2000 Ian H. Giddy
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European Banking 15
The Investment Banking Model
Corporate
Finance
Sales
Customer-Driven
Securities
Goal: Originate deals and sell them in the capital market
as quickly as possible
Capital
Markets
Copyright ©2000 Ian H. Giddy
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European Banking 16
What Strategy?
Client-Arena-Product Matrix
Markets covered
Clients served
Copyright ©2000 Ian H. Giddy
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European Banking 17
Products
Credit products
 Trading and positioning
 Risk management products
 Financial engineering and structured
finance
 Underwriting and distribution
 Asset management
 Retail and private client services
 Transactions services

Copyright ©2000 Ian H. Giddy
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European Banking 18
Range of Financial Services
Firms
American Express
FDIC
Insured
Depository
Consumer
Loans
•
•
Credit
Cards
•
Mortgage
Banking
•
•
AT&T
Commercial
Lending
•
Mutual
Funds
Securities
Insurance
•
•
•
•
•
•
•
•
•
•
•
Bankers Trust
•
¤
Citicorp
•
•
•
•
•
Ford
•
•
•
•
•
•
General Motors
•
•
•
•
•
General Electric
•
•
•
•
•
ITT
•
•
•
•
•
John Hancock
•
•
•
•
•
•
•
J.P. Morgan
•
¤
•
•
•
Merrill Lynch
•
•
•
•
•
•
•
•
•
•
•
•
Primerica
•
•
•
•
•
Prudential
•
•
•
•
•
•
•
•
Sears, Roebuck
•
•
•
•
•
•
•
•
•
•
•
Transamerica
•
•
¤ minor involvment
SOURCE: The National Journal, the American Financial Services Association
and Annual Reports.
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 19
NatWest Bank?
NatWest Bank
Clients
Corporations Government Institutions
Products
Securities custody
Asset Management
Private Equity
Insurance
Lending
Deposits
Securitization/Structured
and Project Finance
Equity underwriting
Bond underwriting
Mergers and Acquisitions
Credit cards
Trading
- Money market
- FX and derivatives
- Interest rate derivatives
- Bonds
- Securitized products
- Futures
Mortgages
Stock brokerage
Corporate Advisory
Private Banking
Copyright ©2000 Ian H. Giddy
High net worth Retail
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
www.giddy.org
European Banking 20
Product Profitability Cycle

Excess returns

Do you want to be a
Nescafe bank?
Or a Starbucks bank?
Time
Copyright ©2000 Ian H. Giddy
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European Banking 21
Client-Arena-Product Matrix
Build versus buy?
Markets covered
Clients served
Copyright ©2000 Ian H. Giddy
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European Banking 22
Client-Arena-Product Matrix
Deutsche Bank in USA
Markets covered
Clients served
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 23
Client-Arena-Product Matrix
Sell?
Markets covered
Clients served
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 24
Using Industry Structure Analysis
SUBSTITUTES
Questions:


Do substitutes exist?
What is their price/
performance?
Potential Action:


SUPPLIERS
Fund venture capital and
joint venture to obtain
key skills
Acquire position in new
segment
Questions:


Questions:
Is supplier industry
concentrating?
Is supplier value/cost
added to end product high,
changing?

COMPETITIVE

ADVANTAGE
Potential Actions:

CUSTOMERS
Is the customer base
concentrating?
Is value added to
customer end product
high,changing?
Potential Actions:
Backward - integrate


Create differentiated
product
Forward - integrate
BARRIERS TO ENTRY
Questions:



Do barriers to entry exist?
How large are the barriers?
Are they sustainable?
Potential Actions:


Copyright ©2000 Ian H. Giddy
Acquire to achieve scale in
final product or critical
component
Lock up supply of critical
industry input
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European Banking 26
Complementarity and Cross-Selling
Insurance
Retail
Citigroup?
Wholesale
Asset Management
Copyright ©2000 Ian H. Giddy
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European Banking 27
The Future of Banking:
Where Do You Want To Go Today?
Banks vs. Markets
 Relationships vs. Transactions
 On Balance Sheet vs. Off
 Domestic vs. Regional vs. Global
 Debt vs. Equity
 Bricks vs. Bytes

Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 28
Corporate Finance
CORPORATE FINANCE
DECISONS
INVESTMENT
FINANCING
PORTFOLIO
RISK MGT
MEASUREMENT
CAPITAL
DEBT
EQUITY
TOOLS
M&A
Copyright ©2000 Ian H. Giddy
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European Banking 29
The CFO Questions





How fast can we grow? What criteria for
spending money? Acquisitions? Divestitures?
How should we finance our growth? What kind
of equity? What’s our exit plan? Private or
public?
How much (cheap) debt should we have?
What kind of debt should we have? Maturity?
Fixed/floating? Currency? Asset-backed?
Hybrids, such as convertibles?
How should we manage our financial risks?
Copyright ©2000 Ian H. Giddy
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European Banking 30
Financing X Inc
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European Banking 31
Financing X Inc
Copyright ©2000 Ian H. Giddy
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European Banking 32
Financing X Inc
Copyright ©2000 Ian H. Giddy
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European Banking 33
Corporate Financing Life-Cycle
Leverage
Growth companies
Copyright ©2000 Ian H. Giddy
Mature companies
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European Banking 34
Firm Characteristics as Growth
Changes
Variable
Risk
Dividend Payout
Net Cap Ex
Return on Capital
Leverage
High Growth Firms tend to
be above-average risk
pay little or no dividends
have high net cap ex
earn high ROC (excess return)
have little or no debt
Stable Growth Firms tend to
be average risk
pay high dividends
have low net cap ex
earn ROC closer to WACC
higher leverage
Earnings
0
Gearing
Copyright ©2000 Ian H. Giddy
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European Banking 35
Financing Growth Companies:
The Agenda
Where can we get the initial equity
financing we need to grow?
 Do we want money, management, or
more?
 When do we want to sell out, and how?
 When is the right time for debt for a
growth company? What kind?

Copyright ©2000 Ian H. Giddy
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European Banking 36
First, Why Equity?

Benefits of Equity
Flexibility:
cannot afford to have fixed
obligations
Strategic partners
Interventionist partners

Disadvantages
No
tax shield
Expensive!
Copyright ©2000 Ian H. Giddy
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European Banking 37
What Kind of Equity?

Sources of Equity
Private
investors
Strategic investors
Interventionist investors
Public market

And Kinds
Common
stock
Stock with restricted voting rights
Hybrids, including convertibles
Copyright ©2000 Ian H. Giddy
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European Banking 38
.comfax




Started in September 1997, .comfax enables users to
send faxes and receive faxes over the internet at a
low cost.
By June 1998 the company had expanded its
services and was signing up subscribers at the rate
of 100,000 a day.
Initial funding was “Angel” finance, but now the
expansion was exceeding the company’s financial,
physical and managerial capacity. On two occasions
it had literally run out of money.
What form of equity financing would be appropriate
for .comfax?
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 39
Pre-IPO Equity Financing
Friends and family
 Angel
 Venture capital
 Strategic partners

Copyright ©2000 Ian H. Giddy
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European Banking 40
Pre-IPO Equity Financing
Friends and family
 Angel
 Venture capital
 Strategic partners

Copyright ©2000 Ian H. Giddy
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European Banking 41
Private Equity Funds
Private equity funds are generally
structured as partnerships specializing
in venture capital, leveraged buyouts,
and corporate restructuring.
 The private equity fund mobilizes funds,
selects and monitors investments,
eventually exiting the investment and
paying back the investors.

Copyright ©2000 Ian H. Giddy
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European Banking 42
Silipos Inc
Copyright ©2000 Ian H. Giddy
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European Banking 43
Silipos Inc, 1999
Debt?
IPO?
Where do
you want
to go?
Acquisition?
Sell?
Copyright ©2000 Ian H. Giddy
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European Banking 44
IntraLinks
Copyright ©2000 Ian H. Giddy
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European Banking 45
IntraLinks’ Choices




Issue debt, either by borrowing from one of the big
New York banks keen to get more involved in
promising Internet businesses, or by means of a
private placement of debt notes, possibly with
“sweeteners” such as warrants to attract a lender.
Seek out one or more private equity investors,
ones who believed in the company’s product and
its management.
Do an initial public offering (IPO).
Find another corporation who would be willing to
acquire IntraLinks.
Copyright ©2000 Ian H. Giddy
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European Banking 46
Why Venture Capitalists Prefer Preferred
Senior status in bankruptcy
 Does not put a value on the shares
 Is convertible into common stock before
the IPO
 Conversion price is set such that if there
is a liquidation all the money goes to the
preferred shareholders (equity is worth
zero)

Copyright ©2000 Ian H. Giddy
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European Banking 47
Case Study: Photronics
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European Banking 48
Case Study: Photronics
Photronics is the world's leading and fastest
growing manufacturer of photomasks.
Photomasks are high precision quartz plates that
contain microscopic images of electronic
circuits. A key element and enabling technology
in the manufacture of semiconductors,
photomasks are used to transfer circuit patterns
onto semiconductor wafers during the fabrication
of integrated circuits. They are produced in
accordance with circuit designs provided by
customers at strategically located manufacturing
facilities in North America, Europe and Asia.
Copyright ©2000 Ian H. Giddy
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European Banking 49
Case Study: Photronics
Sales, 1994-99
Balance Sheet, end-1999
USD millions
Assets
Cash
7.6
Other current assets
59.9
Long term assets
319.6
Total
387.1
Market capitalization
D/E
D/(D+E)
Copyright ©2000 Ian H. Giddy
Book
0.90
0.47
Liabilities & Equity
Current liabilities
Long term liabilities
Shareholder's equity
Total
720 P/E
EBIT/Int cost
Market
0.25
0.20
www.giddy.org
50.2
132.7
204.2
387.1
26x
5.77
European Banking 50
The Company’s Debt
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European Banking 51
Should Photronics Have More Debt?

Benefits of Debt
Tax
Benefits
Adds discipline to management

Costs of Debt
Bankruptcy
Costs
Agency Costs
Loss of Future Flexibility
Copyright ©2000 Ian H. Giddy
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European Banking 52
How Much Debt? Relative Analysis
The “safest” place for any firm to be is close to
the industry average
 Subjective adjustments can be made to these
averages to arrive at the right debt ratio.
 Higher
tax rates -> Higher debt ratios (Tax benefits)
 Lower insider ownership -> Higher debt ratios
(Greater discipline)
 More stable income -> Higher debt ratios (Lower
bankruptcy costs)
 More intangible assets -> Lower debt ratios (More
agency problems)
Copyright ©2000 Ian H. Giddy
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European Banking 53
The CFO Questions





How fast can we grow? What criteria for
spending money? Acquisitions? Divestitures?
How should we finance our growth? What kind
of equity? What’s our exit plan? Private or
public?
How much (cheap) debt should we have?
What kind of debt should we have? Maturity?
Fixed/floating? Currency? Asset-backed?
Hybrids, such as convertibles?
How should we manage our financial risks?
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 54
Raising Equity:
The Investment Banker’s Job
Market conditions
 Corporate needs
 Valuation
 Information
 Distribution

Copyright ©2000 Ian H. Giddy
www.giddy.org
Teleko
m
European Banking 55
Deutsche Telekom: The Sequence

See case Exhibit 2
Copyright ©2000 Ian H. Giddy
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European Banking 56
What’s a Company Worth
to Investors?
Required Returns
 Types of Models

Balance
Teleko
m
sheet models
Dividend discount & corporate cash flow
models
Price/Earnings ratios
Option models

Estimating Growth Rates
Copyright ©2000 Ian H. Giddy
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European Banking 57
Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
Value of
Liabilities
 Book
 Market
Value of Equity
Copyright ©2000 Ian H. Giddy
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European Banking 58
Deutsche Telekom: Book Value

See case Exhibit 3
Copyright ©2000 Ian H. Giddy
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European Banking 59
Relative Valuation

Do valuation ratios make sense?
• Price/Earnings (P/E) ratios
 and variants (EBIT multiples, EBITDA multiples,
Cash Flow multiples)
• Price/Book (P/BV) ratios
 and variants (Tobin's Q)
• Price/Sales ratios

It depends on how they are used -- and
what’s behind them!
Copyright ©2000 Ian H. Giddy
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European Banking 60
Deutsche Telekom:
Ratios and Comparables

See case page 9
Copyright ©2000 Ian H. Giddy
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European Banking 61
Discounted Cashflow Valuation:
Basis for Approach
t =n CF
t
Value= 
t
t =1(1+r)
where

n = Life of the asset
 CFt = Cashflow in period t
 r = Discount rate reflecting the riskiness of
the estimated cashflows
Copyright ©2000 Ian H. Giddy
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European Banking 62
Deutsche Telekom: Earnings

See case page 8
Copyright ©2000 Ian H. Giddy
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European Banking 63
Valuing a Firm with DCF:
An Illustration
Historical
financial
results
Adjust for
nonrecurring
aspects
Gauge
future
growth
Projected sales
and operating
profits
Adjust for
noncash
items
Projected free cash flows
to the firm (FCFF)
Year 1
FCFF
Year 2
FCFF
Year 3
FCFF
Year 4
FCFF
Discount to present using weighted
average cost of capital (WACC)
Present
value of free
cash flows
Copyright ©2000 Ian H. Giddy
+ cash,
securities &
excess assets
- Market
value of
debt
www.giddy.org
…
Terminal year FCFF
Stable growth model
or P/E comparable
Value of
shareholders
equity
European Banking 64
Ian H. Giddy
Stern School of Business
New York University
44 West 4th Street, New York, NY 10012, USA
Tel 212-998-0332; Fax 917-463-7629
ian.giddy@nyu.edu
http://giddy.org
Copyright ©2000 Ian H. Giddy
www.giddy.org
European Banking 68